Optimal Debt Financing and the Pricing of Illiquid Assets

University of California, Los Angeles (UCLA); National Bureau of Economic Research (NBER)

Date Written: March 14, 2011

Abstract

We develop a model in which the equilibrium returns of illiquid assets are determined by the debt capacity of arbitrageurs rather than the desire to smooth consumption shocks. Debt allows risk-neutral arbitrageurs to earn a spread between the asset's expected cash flow and its equilibrium price, but increases the likelihood they will be unable to meet a margin call in which case they are forced to liquidate the asset at a discount to its fundamental value. We show that the costs of debt are convex and impose a "limit to arbitrage." Consequently, even though arbitrageurs are risk neutral, the asset earns a risk premium in equilibrium and the risk premium is larger when the aggregate debt capacity among the arbitrageurs is smaller. In particular, the asset's risk premium is larger when the asset is more illiquid, margin constraints are tighter, and expected money flows to the arbitrageurs is low.

SSRN Rankings

About SSRN

We use cookies to help provide and enhance our service and tailor content.By continuing, you agree to the use of cookies. To learn more, visit our Cookies page.
This page was processed by aws-apollo5 in 0.172 seconds